OFS Capital’s (OFS) credit performance as of the IIQ 2024 was BELOW AVERAGE

INTRODUCTION

Now that the IIQ 2024 BDC earnings season is all but over, we’re reviewing the credit performance of each BDC – looking both at the most recent developments and long-term trends. This seems especially timely with all the loose talk about a recession round the corner – typically not good news from a credit standpoint. To be both systematic and even handed, we’re rating each BDC’s credit performance as ABOVE AVERAGE; NORMAL, BELOW AVERAGE or VERY POOR. We’re trying to incorporate a host of data points in these evaluations, but there’s always a degree of subjectivity involved. We began with Crescent Capital BDC (CCAP) and followed up with WhiteHorse Finance (WHF) and Runway Finance (RWAY). After much research, we’re now ready to discuss OFS Capital (OFS) which – unfortunately – seems to be in poor credit shape.

On All Fronts

Yes, OFS managed to report an increase in its Net Asset Value Per Share (NAVPS) in the IIQ 2024 of 3.9%. Don’t let that mislead you. That was the first quarter in the black after 8 consecutive quarters of NAVPS losses. Since the end of 2021, this key metric has declined by (24%), this latest period notwithstanding. The gain related principally to an increase in the value of the OFS equity investment in Pfanstiehl Holdings, Inc. This investment has been a great boon for OFS over the years, paying out a handsome dividend, but is prone to fluctuations in value.

Gone

OFS actually incurred ($4.3mn) in net realized losses. The biggest loss was incurred from the settling out of its $2.6mn second lien loan to Astro One Acquisition. $0.2mn was received and ($2.4mn) booked as a realized loss. There was also a loss recognized on the sale of CLO securities, to the tune of ($1.9mn).

Track Record

We’ve taken to calculating a BDC’s realized losses over time – a much more useful indicator of how credit underwriting is working out than any one quarter ‘ssnapshot. Where OFS is concerned: and going back to the beginning of 2019, net realized losses have come to ($51mn) – a significant amount for a BDC whose par equity has averaged $186mn or so in this 5.5 year period. That (27%) of capital lost to investments – mostly loans – gone wrong. Over this period, Net Investment Income (NII) amounted to $126mn, so realized losses have taken a 41% bite out of recurring earnings. That’s very high by BDC standards. Admittedly, we’ve only recently began calculating this metric for every BDC and have completed the calculation for only 14 BDCs. Still, OFS has the worst percentage of all.

Not Great

If only we could say that was all in the past, but the present does not look very good either and – as we’ll discuss – and the future even worse. Going by the BDC’s own 7 point investment rating system, ($76mn) of debt invested at cost is under-performing. That’s a whopping 28% of all debt owned. This translates into $46mn at FMV or 19% of all debt, excluding equity and CLOs owned. Very loosely, we consider 15% or less to be NORMAL for a BDC, which is not the case here.

Not Performing

Included in those underperforming numbers are the BDC’s 6 non-performing companies. That number is down from 7 but only – as we’ve seen – due to the loss booked on Astro One. The FMV of the non-accruals is said to be $18mn in a total portfolio with a value of $398mn, of which $266mn is in debt. Non-performing debt at FMV comes to a too high 7.6%. The BDC Credit Reporter has reviewed each of the non-performers and 4 have a significant value remaining: $3mn or greater. (That’s partly because Master Cutlery is in deep trouble as its loan became contractually due on May 25, 2024. The lenders have filed a motion to receive a final recovery payment from the portfolio company but OFS has written its value to nearly zip). Further losses may yet occur at Planet Bingo (down this quarter), SSJA Bariatric (flat this quarter) and 2 other troubled companies.

Long List

If $46mn of debt is underperforming and $18mn is non-performing, that leaves $28mn of debt in still current – but troubled – loans. OFS – like all its peers – does not specifically announce who’s on their watch list. However, the BDC Credit Reporter does undertake that sort of analysis for its Premium subscribers. Our sister publication found 11 underperformers, 7 of whom are still paying their interest, but might not in the future – rated 3 or 4 on our own 5 point scale. Given that OFS has only 40 borrowers on its books, the fact that more than a quarter are not performing well is disturbing, especially taken with all the other metrics already mentioned.

Portfolio Construction

As we’ve noted, OFS suffers from having a relatively small, concentrated loan portfolio. Moreover, 15% of the debt is in second lien. Even amidst the first lien loans some are structured as “last out” arrangements where OFS has agreed with another lender to be the first to incur any losses should any occur. This may explain why the yield on the OFS “income-producing asset” portfolio is 13.7%. This suggests relatively high risk investing.

Another Twist

Another challenge is that 23%of the portfolio at cost is in the form of CLO securities: famous for generating a high cash yield but also for depreciating in value over time. The cost of those securities is $90mn and the FMV $76mn – a (14%) discount already.

Less Than

Even the OFS preferred and equity positions ex-Pfanstiehl – are not performing all that well, with an aggregate cost of $15mn, matched with a similar value. Only Pfanstiehl – if sold – could help generate income but the company has paid out dividends in the past which would no longer be the case if sold. Outside of this exception to the rule, OFS has little else to look forward to in its equity stakes that could offset past and future credit losses.

Educated Guesswork

The BDC Credit Reporter – looking at only the “Important Underperformers” – estimates further losses on 5 troubled companies could amount to ($15mn), about (10%) of the BDC’s net assets. On a pro-forma basis that would bring the OFS NAVPS from $11.51 to $10.39. Again, we’re not done calculating this metric for every BDC but OFS ranks last amongst those the BDC Credit Reporter has done the calculations on.

View From The Top

Going by what has been said on the most recent OFS conference call, management does not concede that there is anything wrong with the portfolio from a credit standpoint:

Turning to our portfolio. We believe it is well positioned for the current macroeconomic environment. As part of our long-standing investment discipline, we remain committed to avoiding highly cyclical industries. We believe that our loan portfolio remains well diversified and defensively positioned. At quarter end, our largest sector exposures at fair value are in manufacturing, healthcare, wholesale trade and business services.Another key part of our investment discipline is investing higher in the capital structure, with approximately 100% of our loan portfolio at fair value and first lien and second lien senior secured loans…We had no new nonaccruals this quarter, and we believe the overall quality of the portfolio remains stable

CONCLUSION

Sorry To Say

Our credit review finds the OFS credit performance BELOW AVERAGE by our standards and at risk of slipping into our lowest – and worst category – of VERY POOR. This is akin to “death by a thousand cuts” rather than a rapid downturn but the credit trend is definitely not a friend to OFS or its shareholders. Not helping is that the portfolio at cost has shrunk in size by (16%) since the end of 2021. Just looking back two years you’ll see OFS generating NII of $6.2mn. In this latest quarter, NII has dropped (45%) to $3.4mn. How long can this go on for, especially with interest rates set to drop? A very rough calculation has the BDC’s NII falling by nearly 50% if SOFR drops from 53.% to 2.3% and that’s before budgeting for any incremental bad debts.